I write primarily about the U.S. public and private retirement system. Trained in economics (1999 PhD from MIT), I serve as the William Karnes Professor of Finance and Director of the Center for Business and Public Policy at the University of Illinois. I am also Associate Director of the Retirement Research Center at the National Bureau of Economic Research (NBER). Previously, I served as Senior Economist with the President’s Council of Economic Advisers, as staff to the President’s Commission to Strengthen Social Security, and as a Member of the Social Security Advisory Board. I am also a Trustee for TIAA-CREF, a Fortune 100 financial services firm serving the not-for-profit sector.

U.S. Public Pension Plans are Different (and Not in a Good Way!)

ANNAPOLIS, MD - MARCH 14: Members of the American Federation of State, County and Municipal Employees Union, participate in a rally in front of the Maryland State Capitol building on March 14, 2011 in Annapolis, Maryland. The rally was held to protest Governor Martin O'malleys (D-MD) proposed changes to state workers pensions. (Image credit: Getty Images via @daylife)

I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S. The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!) Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.

On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior. Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.

Well, now we have such evidence. Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?” In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe. What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are. Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.

Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.” As I have written before, this is an intellectually vacuous approach to discounting. What I had not fully realized is how unique this mistake is to U.S. public plans. The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.

The most striking finding is the impact that this difference in accounting has on real behavior. The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.”This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.

There are many losers from GASB-induced deception. Public workers end up with less-well-funded pensions. Taxpayers end up bearing financial risk without realizing it. Investors in public debt are given inaccurate information about the size of the pension liabilities. Isn’t it time that we fix this?

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Thanks for pointing out this study in which the authors call for “drastic reform.” This study joins recent work by the Mossavar-Rahmani Center at Harvard Kennedy School, the Cleveland Fed, Government Accountability Office and latest data from the Census Bureau in proving beyond doubt that our municipal and state pensions are heading for a hard crash. Please take a look at these. http://www.statebudgetsolutions.org/publications/detail/latest-studies-show-growing-pension-peril

Frank – indeed, there have been numerous studies pointing out the financial mess that our public sector pensions are in. This is not the fault of those in them … but it is the fault of legislatures that failed to fund and the GASB rules that provided them cover.

Certainly, Jeffrey. I’m not worried about who’s fault it is, I worry about who’s problem it is. Who is going to pay for this? If politicians, public workers and union leaders think average taxpayers who already have been sucker punched and mugged by Wall Street, then forced to pay $16 trillion to the guys who did it, (check the GAO study Bernie Sanders ordered) are going to quietly pay for the false pension promises politicians made, they are going to be in for a shock. In a democracy, citizens get to say NO! There are real solutions, which if imposed now can ameliorate and possibly even prevent the ultimate catastrophe. Blame, lies and denial are not among the viable solutions. One thing I know for sure: It’s not taxpayers’ fault. We offer real solutions: http://www.statebudgetsolutions.org/

LCR – with regard to your last point “unless you work for a private sector employer who has gone bankrupt and you have little or no pension left” — this is simply not the case. The Pension Benefit Guaranty Corporation (PBGC) guarantees private sector DB plans when an employer goes bankrupt with an underfunded pension. They guarantee benefits up to a cap, so benefits for high pension individuals are partly at risk, but we are talking on the order of $50,000+ per year. So I am hard pressed to see an example in recent history of someone in the private sector with “little or no pension left.”

There is either a glaring oversimplification or purposefully misleading implication in your article: You haven’t differentiated between the federal government’s pension system and that of state and local governments. With the Reagan-era federal pension overhaul in 1984, the federal pension system is now both fully-funded and required to invest only in Treasury bonds by law. By describing all public pensions in the same way you’ve either inadvertently, or worse, intentionally attempted to erode confidence in the public sector. I think that’s unfortunate. Check out a Congressional Research Service paper on the federal pension system if aren’t familiar with it (http://www.bankrate.com/finance/retirement/CRS-report-on-federal-employees-retirement.pdf) as seems obvious from your article.

Hagen, My writings about GASB pertain to state and local public pension plans. If you read enough of my articles, you will see that. But apologies if I failed to make that clear in this post. It is not an “intentional attempt to erode confidence in the public sector.” Is it really necessary to impugn my motives in your response? I am a public sector worker myself. Have been an employee of both the federal government and state government, as well as both for-profit and not-for-profit employers in the private sector. I am writing as an economist, and my goal is simply to point out the flaws in economic policy and thinking where Isee them. Jeff

The other aspect of this article’s implications is that the actuarial reduction of a state pension when a beneficiary such as a spouse is named on retirement also does not adjust for current interest rates. Thus, this failure to adjust advantages younger retirees. The reduction is less for younger retirees because a high return is assumed in the actuarial calculation. Under current low rates of return, one would assume if a retiree delays retirement by a few years, the reduction would decrease since the number of years the retiree and spouse are expected to live is reduced by the same few years. However, since a high return is assumed, the pension reduction is not as proportionally large for younger retirees. This in turn makes the pensions more vulnerable to default by encouraging earlier retirement and paying out a higher than justified monthly check. It would be interesting to hear comments on this effect of actuarial assumptions on the size of the monthly pension check.

Imarzil, Sadly, the inappropriate use of discount rate parameters does apply to more than just the discounting issue. In my own system – the State Universities Retirement System (SURS) of Illinois – the Board has consistently used an annuity conversion factor that is way out of line with any reasonable assumptions for pricing annuities. It amounts to an implicit wealth transfer to retirees who retiree under what is known as the “money purchase option,” and it results in a significant increase in program costs. Jeff